By Andy Ives, CFP®, AIF®
The pro-rata rule is the formula used to determine how much of a distribution is taxable when an IRA account consists of both pre-tax and after-tax (basis) dollars. The rule requires that all SEP, SIMPLE, and traditional IRAs be considered as one giant “Starbucks Venti mug of money” for every distribution or Roth conversion. When both pre- and after-tax dollars exist, one cannot just withdraw or convert the basis. (It is important to note that Roth IRAs are NOT factored into the pro-rata equation.)
A popular analogy for pro-rata is the “cream in the coffee” comparison. Once a spoonful of cream goes into a cup of coffee, it becomes inexorably mixed and can never be removed as just cream. Each future sip will consist of a percentage of cream and a percentage of coffee. For a person who does not like cream, there is no way to “re-set” the cup so that it is 100% coffee. Similar with pro-rata, one cannot only withdraw the creamy basis or covert it to a Roth IRA.
For example, consider Jake. Jake has a traditional IRA worth $50,000, of which $20,000 is basis (after-tax). Jake also owns a second IRA at another bank worth $150,000, but it is entirely pre-tax dollars. Jake asks his advisor to convert only the $20,000 in his small IRA to a Roth. Jake reasons that since he already paid tax on this basis money, he can do the conversion for “free.”
“No can do,” says his advisor, correctly. Pro rata requires all IRAs be considered. Since only 10% of ALL of Jake’s IRAs is basis ($20K of $200K total), if Jake converts $20,000, then 90% of the conversion amount ($18,000) will be taxable. Jake doesn’t pay taxes twice on these dollars – the basis NOT converted is essentially left in the traditional IRA.
After the conversion, Jake maintains the same 90/10 combined pre-tax/after-tax ratio in his two traditional IRAs. (His new mix is $162K pre-tax/$18K basis.) $150,000 remains in the big IRA, and $30,000 in the small IRA. Jake will also have a brand-new $20,000 conversion Roth IRA consisting of 100% after-tax dollars – the $18,000 he just paid taxes on, plus $2,000 of his original basis.
Was there any way to go about this conversion differently? Could Jake have converted only the original $20K basis? A-ha! While there is no way to “re-set” a cup of coffee mixed with a spoonful of cream, there IS a way to “re-set” a traditional IRA with basis. Let’s rewind our example. Jake still has the same $150,000 and $50,000 IRAs, and $20,000 basis remains in the small IRA. No conversions have happened yet. Jake wants to convert only the $20,000 basis.
Enter the “Magic Coffee Filter & Cream Extractor.” Jake has a 401(k) through his employer that accepts rollovers.
After-tax dollars (basis) are ineligible to be rolled into a 401(k). This is a broad rule which applies universally to all 401(k) plans. However, pre-tax IRA dollars can be rolled into a 401(k). Jake rolls over his entire large IRA ($150,000) and the $30,000 in pre-tax dollars of his small IRA to his company work plan. The $20,000 of basis remains in Jake’s IRA, because the 401(k) will not accept it. After the rollovers are finalized, Jake asks his advisor to convert the $20,000 left behind in his IRA to a Roth. The conversion of basis is completed tax-free. The cream has been removed from the coffee.
The pro-rata rule is the formula used to determine how much of a distribution is taxable when an IRA account consists of both pre-tax and after-tax (basis) dollars. The rule requires that all SEP, SIMPLE, and traditional IRAs be considered as one giant “Starbucks Venti mug of money” for every distribution or Roth conversion.